Nepal is a post-conflict state seeking to formalize democracy in a challenging environment. Significant headway toward a new state has been made since the 2006 peace accord. Progress on a range of technical issues (including public financial management, monetary policy, and financial sector supervision) has also been achieved. However, the failure of the constituent assembly to meet an end-May 2012 deadline to ratify a new constitution is a serious setback, and a major impediment to macroeconomic management and prospects for growth. The subsequent dismissal of the constituent assembly in June 2012 has left day-to-day operations in the hands of a caretaker government. New elections are notionally slated for April 2013, but will require fractured political parties to agree on an interim consensus government. In the meantime, key articles of legislation (such as the government budget) have been delayed. More broadly, the lack of a consensus government and functioning parliament appear to be dampening investment (foreign and domestic), keeping potential donor support at bay, and undermining prospects for sensitive financial sector and state enterprise reforms.

On November 16, 2012, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Nepal.1

Background

Nepal remains in an important political transition, but the lack of political consensus complicates macroeconomic management. The dissolution of the constituent assembly in May has delayed significantly the passage of a full-year government budget for 2012/13 and other key pieces of legislation. Higher growth and progress in poverty reduction could be enabled by political consensus, policy stability, an easier labor environment, and more effective use of external support.

Macroeconomic performance improved in 2011/12 despite lingering financial sector vulnerabilities and an uncertain political environment. Real GDP growth accelerated to 4.6 percent, reflecting a strong agricultural harvest, and a vibrant services sector—driven partly by a resurgence of inward remittances. Average headline inflation declined to 8.3 percent on the back of subdued food prices, but nonfood inflation was over 9 percent. The balance of payments registered a record surplus, and the Nepal Rastra Bank’s (NRB) foreign exchange reserves increased to $4.3 billion (6.8 months of imports). The government fiscal deficit was smaller than expected. Revenue targets were largely achieved, but capital expenditures were lower than budgeted. Public debt remained constant as a share of GDP. However, quasi-fiscal liabilities continued to rise through financial losses at the Nepal Electricity Authority and Nepal Oil Corporation.

Stress on the financial sector receded with strong remittances, but serious balance sheet and other risks remain. The influx of remittances eased liquidity conditions, allowing banks to unwind support provided by the NRB. Financial soundness indicators show some improvement, but concerns remain about the reliability of reported data. Profitability remains low and extension of new private sector credit was tepid. The authorities rendered support to bank balance sheets through accommodative monetary policy and extended forbearance, but have also strengthened supervision and regulation. Revision of the legal framework for bank resolution is under way, and recapitalization plans have been announced and partially implemented for two insolvent state banks. However, significant restructuring of the financial system has yet to emerge, and balance sheet risks from concentrated exposure to a moribund real estate market are high.

The outlook for 2012/13 is challenging. Real GDP growth is projected to decline to 3.8 percent, reflecting a weaker monsoon, and slower services activity as remittance growth may slow. Spillover effects from declining growth in India (through lower export demand, weaker inward investment, and possibly less remittances), and the dampening effect of continued political uncertainty will also present further challenges to growth in Nepal. Inflation is also on the rise, and upward pressure on prices may increase in line with projected developments in India over the next few months.

Executive Board Assessment

Executive Directors welcomed Nepal’s improved macroeconomic performance and progress on structural reforms despite the difficult political environment. However, Directors noted that downside risks are increasing because of spillover effects from the slowing Indian economy, a protracted political transition, and stresses in the financial sector. To secure macroeconomic stability and to foster sustainable and inclusive growth, Directors emphasized continued commitment to sound policies and structural reforms, particularly in the financial sector.

Directors advised continued fiscal prudence, consistent with the objective of keeping public debt roughly constant over the medium term. They called on the authorities to act expeditiously to pass a full-year budget for 2012/13 and to strengthen public financial management to ensure full execution of the capital budget. Directors stressed the need to address the quasi-fiscal liabilities arising from financial losses at the Nepal Oil Corporation and the Nepal Electricity Authority. Recognizing the difficult political situation, they encouraged the authorities to build consensus to gradually adopt an automatic price adjustment mechanism, while putting in place well-targeted subsidies to protect the vulnerable. Reform of the pension system should also be considered. Directors commended the enhanced revenue mobilization efforts but saw scope for further tax and customs administration reforms.

Directors welcomed the steps taken by the authorities to stabilize the financial sector. To address the underlying vulnerabilities and to strengthen the system, they emphasized the need for a targeted and well sequenced acceleration of financial sector reforms, including the amendment of NRB Act to improve the governance of the financial sector and the broadened prompt corrective action framework. Enhancing supervision and improving the quality of data will also be necessary for increasing financial sector stability. Directors also called for further progress on the AML/CFT framework. They welcomed the authorities’ interest in an FSAP.

Directors considered that a tightening of monetary policy appears warranted to signal commitment to price stability and support the exchange rate peg, which has served the country well. They agreed that open market operations and regular auction of T-bills should be used to mop up excess liquidity.

Directors concurred that accelerating the pace of structural reforms will be important to address competitiveness challenges, and achieve higher and more inclusive growth. Efforts should focus on enhancing the business environment, removing infrastructure bottlenecks, increasing transparency, and improving governance.

Public Information Notices (PINs) form part of the IMF’s efforts to promote transparency of the IMF’s views and analysis of economic developments and policies. With the consent of the country (or countries) concerned, PINs are issued after Executive Board discussions of Article IV consultations with member countries, of its surveillance of developments at the regional level, of post-program monitoring, and of ex post assessments of member countries with longer-term program engagements. PINs are also issued after Executive Board discussions of general policy matters, unless otherwise decided by the Executive Board in a particular case.

Under Article IV of the IMF’s Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country’s economic developments and policies. On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board. At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of Executive Directors, and this summary is transmitted to the country’s authorities. An explanation of any qualifiers used in summings up can be found here: http://www.imf.org/external/np/sec/misc/qualifiers.htm.